In the world of startup financing, liquidation preference is a crucial term that protects early investors by guaranteeing them a certain payout in the event of a company sale or liquidation. For investors, it provides a safety net, while for founders, it’s essential to understand how liquidation preference can impact their own payout if the company is sold.
This guide explains liquidation preference, discusses its variations, and provides examples to illustrate how these terms impact different shareholders. Additionally, we’ll cover the concept of capped liquidation preferences, which are more founder-friendly.
What Is Liquidation Preference?
Liquidation preference grants preferred shareholders (usually investors) the right to a payout before any funds go to common shareholders if there is a liquidation event—a sale, merger, or bankruptcy. This right ensures that investors are reimbursed for their risk before common shareholders receive anything, which can have significant implications for a founder’s or employee’s payout.
Types of Liquidation Preference
- Non-Participating Preference: Preferred shareholders receive a fixed amount (often a multiple of their investment) but do not participate further in the remaining assets.
- Participating Preference: Preferred shareholders receive an initial payout and also participate in any remaining funds alongside common shareholders.
- Capped Preference: Limits the total payout to preferred shareholders to a specified multiple of their original investment.
Example Scenarios to Understand Liquidation Preference
Consider a fictional startup, Venture Tech Ltd., which raised Series A funding:
| Company Details | Value |
|---|---|
| Common Shares Outstanding | 5,000,000 |
| Series A Investment | $2,000,000 for 2,500,000 preferred shares |
| Purchase Price per Preferred Share | $0.80 |
| Liquidation Preference Multiple | 2x |
The term sheet also states that preferred shareholders receive 2x the purchase price per share before common shareholders and participate in any remaining assets.
Example A: Sale Price of $6 Million
| Step | Calculation | Result |
|---|---|---|
| Initial Payment to Preferred | $0.80 x 2 x 2,500,000 | $4,000,000 |
| Remaining Proceeds | $6,000,000 – $4,000,000 | $2,000,000 |
| Distribution to Preferred | $2,000,000 x (2.5 / 7.5) | $666,666 |
| Distribution to Common | $2,000,000 x (5 / 7.5) | $1,333,333 |
Total Payouts:
- Preferred Shareholders: $4,666,666
- Common Shareholders: $1,333,333
Example B: Sale Price of $10 Million
| Step | Calculation | Result |
|---|---|---|
| Initial Payment to Preferred | $0.80 x 2 x 2,500,000 | $4,000,000 |
| Remaining Proceeds | $10,000,000 – $4,000,000 | $6,000,000 |
| Distribution to Preferred | $6,000,000 x (2.5 / 7.5) | $2,000,000 |
| Distribution to Common | $6,000,000 x (5 / 7.5) | $4,000,000 |
Total Payouts:
- Preferred Shareholders: $6,000,000
- Common Shareholders: $4,000,000
Example C: Company-Favored Capped Preference
If the payout to preferred shareholders is capped at 4x the purchase price per share:
| Cap Calculation | 4 x $2,000,000 | $8,000,000 |
|---|---|---|
| Break-Even Sale Price | (y – 4) x (2.5 / 7.5) = 8 – 4 | y = $16 million |
Preferred shareholders can receive a maximum of $8 million if the sale price is at least $16 million. Any amount beyond this goes to common shareholders, making this a more company-favored structure.—
Key Takeaways on Liquidation Preference
- Investor Protection: Liquidation preference ensures investors are compensated first in adverse situations.
- Impact on Common Shareholders: High multiples and participation rights can limit the payout for common shareholders.
- Capped Preferences: Limiting the payout for preferred shareholders can make deals fairer for founders and employees.
Frequently Asked Questions (FAQs)
1. What is liquidation preference?
Liquidation preference is a right that ensures preferred shareholders receive a certain payout before common shareholders if the company is sold or liquidated.
2. How does liquidation preference impact common shareholders?
Liquidation preference affects common shareholders because it gives preferred shareholders priority in receiving payouts, often reducing or eliminating payouts for common shareholders if funds are limited.
3. What is a participating liquidation preference?
Participating liquidation preference allows preferred shareholders to receive their initial payout and participate in remaining proceeds with common shareholders.
4. Why might a company cap liquidation preferences?
Caps on liquidation preferences limit the total payout for preferred shareholders, benefiting common shareholders by allowing them to retain more of the proceeds in high-value exits.
5. What’s the typical range for liquidation preference multiples?
Liquidation preference multiples typically range from 1x to 2x the initial investment, ensuring investors get back one to two times their investment amount first.
6. What happens if the sale price is lower than the liquidation preference?
If the sale price doesn’t cover the liquidation preference, common shareholders likely receive nothing, as all funds go to preferred shareholders.
7. How can founders negotiate fair liquidation terms?
Founders can negotiate for lower multiples, non-participating preferences, or capped preferences to balance the deal in favor of common shareholders.
Conclusion
Liquidation preference is essential for balancing the interests of investors and founders in startup financing. For investors, it offers protection; for founders, understanding liquidation preference helps ensure fair outcomes. By structuring these preferences thoughtfully—through multiples, caps, or participation rights—private equity and startups can create mutually beneficial agreements.